Stocks are continuously popping and dropping, and that can make even the most hardened investor question whether selling a position at any point in time is the right decision. To help investors know when it's time to sell a stock, we asked some of our top Motley Fool contributors to share with us how they decide to part ways with an investment. Read on to learn their sell strategies.
Knowing when to sell a stock can be extremely difficult, but what can help is to remember why you bought the stock in the first place. Ideally, you should keep a log of the reasons that led you to consider a given stock and which of those reasons you found most compelling when you decided to buy it. That way, if those conditions change, you'll know that the entire thesis behind your purchase proved to be incorrect, which should give you your first warning that it's probably time to sell.
One great example involves high-yield dividend stocks. Often, a high-yielding stock will run into trouble that eventually forces it to cut its dividend. If the only reason you were holding that stock was because it paid out healthy amounts of income, then a dividend cut is your sign to take a quick exit. Yet many investors get trapped in that situation, holding on in the vain hope that the stock will recover from the adverse conditions that forced it to stop paying full-sized dividends. All too frequently, those stocks continue to lose ground, and it turns out that you would have been better off selling at the first sign of trouble.
If you had multiple reasons to buy, and some of them are still valid, then holding your shares can be a smart move. But going against your primary reason for buying a stock usually doesn't make any sense and can do more harm than good.
Everyone's investing process is different, so there are multiple ways to know when it's time to sell a stock.
For Graham and Dodd-style value investors, one way to know when it's time to sell a stock is when it trades above the price at which you value it. As Seth Klarman, founder of The Baupost Group and one of the world's top value investors, explained: "There's no such thing as a value company. Price is all that matters. At some price, an asset is a buy, at another it's a hold, and at another it's a sell."
To differentiate among the three, you need to learn the basics of valuation, which include valuing companies based on multiples. However, you can easily be led astray by this approach if you don't take a close look at all of the financials.
As Buffett has said, students of investing really only need "two well-taught courses: How to Value a Business, and How to Think About Market Prices." Any college textbook on valuation will do to get you started, though I recommend Valuation from McKinsey & Co. True value investors can buy the third edition on Amazon.com for $0.01.
Earnings reports and financial metrics can give investors a near-complete picture of a company's financial health, but they can't predict the impact of disruptive threats. If a company is underestimating those threats or failing to protect itself against them, then it could be time to sell. Let's look at a few examples.
Kodak's finances looked solid in the 1970s and 1980s. Although the company invented the first digital camera in 1975, it held the technology back for fear of killing its high-margin film business. When more digital cameras arrived in the 1990s, Kodak foolishly kept its film business alive with digitally coded film and photo CDs instead of biting the bullet and pivoting its entire business toward digital cameras. Eventually, Kodak filed for Chapter 11 bankruptcy protection in 2012.
Back in 2007, BlackBerry (NYSE:BB) and Nokia (NYSE:NOK) seemed like solid investments: The former was the world's top smartphone manufacturer, and the latter was the world's biggest handset-maker. But when Apple (NASDAQ:AAPL) launched the first iPhone in 2007, neither company responded to touch-based smartphones in a timely manner, and the rest is history.
Today, smartphones are killing the market for digital cameras, e-commerce giants are eating big-box retailers alive, and Internet-only streaming services such as Netflix (NASDAQ:NFLX) are persuading people to ditch their cable services. Investors should keep an eye out for disruptive threats by keeping up with industry trends. Recognizing a threat as a company ignores it could help you sell its stock at the right time.
Stocks have a tendency to climb much higher than people think, and that can make it difficult to decide when to take profits. Sell a winning position too soon, and you could be kicking yourself as it continues to go even higher. Hold on to it too long, and you may be kept up at night worrying as you watch all your profit disappear.
To determine when to sell a winning stock, it can help to evaluate portfolio positions based on their position size. For example, a portfolio of 20 equally weighted stocks would have 5% of the portfolio invested in each position. If a position grows to become worth 10% of the portfolio, selling half the position to bring it back down to 5% can allow an investor to book some profit and still benefit from any future growth.
That kind of a strategy can also pay off in another way. Taking a little off the table provides some dry powder in the portfolio that can be spent on another great idea or be reinvested back into the original investment if it pulls back.
Investments aren't people. It's perfectly all right to sever your ties with one and become friendly with another. In fact, I think one of the best reasons to sell a stock is simply because you've found something much better.
The tax code encourages you to look for, and invest in, stocks that are significantly better than those you currently own. A stock you bought for $60 that currently trades for $100 can be sold for after-tax proceeds for $94, assuming you pay a 15% capital gains tax. Thus you need considerable gains from the new investment just to catch up to where you were on the old investment.
Thinking about investments in this way is meant to discourage you from selling too soon or too carelessly. All too often, we buy or sell not because we have a better place to invest, but because we get nervous and want to lock in our gains or losses. Most investors could benefit from being a little pickier about the reasons they buy and sell. Take Buffett's advice and pretend that you can make only 20 trades in your lifetime. Is selling or buying this stock really how you want to spend one of your only allotted trades?
Dan Caplinger owns shares of Apple. Dan Dzombak has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Leo Sun owns shares of Apple. The Motley Fool recommends Amazon.com, Apple, and Netflix. The Motley Fool owns shares of Amazon.com, Apple, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.